November 2, 2021 | 4-minute read (790 words)
When it comes to pricing, entrepreneurs should strive for a nuanced approach that strikes a balance between attracting customers and still earning a profit. To set an appropriate price, you must know how much it costs to develop your product or service. This will include the cost of materials, labor and overhead.
To calculate the cost of your products or services, consider this step-by-step reference.
To calculate the final price of a tangible product, add an additional sum to the total cost of production so that you can earn a profit. The difference between how much it costs you to manufacture the product and the amount you sell it for is referred to as the markup.
Expenses can be organized into three buckets: direct material costs, direct labor costs and manufacturing overhead costs.
Direct material costs refer to the cost of the raw materials needed for production and the equipment used to transform them into finished items.
Direct labor costs refer to wages and benefits for employees who manufacture a product or provide a service. To compute the direct labor cost per production unit:
Manufacturing overhead costs aren't directly related to the production of your goods, and they can be static or variable. Static overhead costs don’t change according to sales volume and must be paid regularly. Examples include warehouse and office rent, interest payments, and the equipment required to run your firm. Variable overhead expenses change from month to month, independent of the number of items sold. Examples include travel costs, furnishings, storage, marketing expenses and power bills.
Indirect labor cost refers to the cost of labor not directly tied to items produced or services rendered. It represents the company's overhead costs required to manage the firm on a day-to-day basis. Indirect labor costs include wages paid to employees whose duties enable others to produce goods and perform services, such as staff members who provide security for the facilities, maintain equipment and manage the office.
- Calculate the direct labor hourly pay rate. To do this, divide the value of salary/wages, benefits and payroll taxes by the number of hours worked in a payroll period.
- Determine direct labor hours needed to produce one unit of your product. To do this, divide the total number of finished goods in a year by the number of direct labor hours.
- Compute the labor cost per unit. To do this, multiply the direct labor hourly rate by the time required to make one unit of the product.
As a service-based business, the price of your service is the minimum you must carry to cover your expenses and labor while making a profit that exceeds your income and administrative expenses. You have the option of invoicing your clients on an hourly or project basis, as illustrated below.
Hourly service rate – To determine the hourly service rate to bill customers:
- Compute your annual billable hours. Take the total number of hours you anticipate working for the year, then subtract nonbillable time (like bookkeeping and billing).
- Compute your total annual cost. Add your yearly overhead and labor expenses, including salary and benefits. Overhead refers to costs related to running a business, such as phone bills, rent, utilities, furnishings, equipment and software.
- Compute the amount you need to charge per hour to cover expenses. Divide your total annual cost by billable hours.
- Compute your hourly service rate. Multiply the value derived above by your profit margin. This amount lets you cover all expenses while still earning your desired profit.
Per-project rate – To determine your per-project rate:
- Estimate the number of hours it will take to finish the job.
- Compute your project base rate. Multiply your hourly service rate by the total number of hours the project will take to finish.
- Next you can opt to add additional pricing to your project base fee to cover any further costs specific to the job. Inform the client of that final price.
- Prepare an estimate for how you'll proceed if the job’s scope exceeds your original assumptions and share it with the client.
- Before settling on pricing for each service the project encompasses, consider these four factors: how much competitors charge; how much target clients are prepared to spend for the service; profit margin (sum of expenses multiplied by your desired margin percentage); and how much time you will spend delivering services.
After spending some time in the industry, you’ll acquire a better sense of whether your prices are accurate. But knowing how to set pricing from the start can help you maximize profit from day one. Don’t forget to stay on top of any changes to the expenses your product or service entails so you can adjust your costs accordingly.